By Derek M Horstmeyer
Investors are displaying a tendency to over-react to news which has never historically been seen before.
Financial researchers have known for decades that investors tend to under-react to news. This shows up in everything from earnings announcements, stock recommendations, analyst reports and ultimately leads to momentum in stock prices. Yet, for the first time ever, since we have emerged from the 2008 crisis, investors are displaying a new form of behavior – over-reacting to big moves in the stock market.
Investigating daily returns for the past 60 years (S&P 500 returns) shows an interesting pattern of investor behavior: Between 1950 and 2007, on 601 occurrences the S&P moved at least one percent in some direction followed by moving the opposite direction in the subsequent day at least half a percent. This denotes a classic over-reaction to news. Contrary to this, between 1950 and 2007, on 851 occurrences the S&P moved at least one percent in some direction followed by moving the same direction in the subsequent day at least half a percent. This is a classic under-reaction to news.
This signals that investors tend to under-react as opposed to over-react with close to a 60/40 split. Yet, following the 2008 crisis this has completely shifted in the opposite direction with nearly a 40/60 split favoring over-reactions: 149 over-reactions and 109 under-reactions. This result holds no matter how you condition the statement or if you become more/less strict with how you categorize an over-reactions and under-reactions (in terms of percentage thresholds).
Why for the first time in history are investors over-reacting instead of under-reacting to news? One theory highlights the changing nature of news that we are exposed to on a daily basis and how investors react to news about growth stocks.
One theory behind this shift highlights how individuals process different types of information. First, people tend to overreact to vivid emotional anecdotes and tend to underreact to new and surprising data. Consider, following a big one day drop in the price, an individual may get a visceral reaction when they think about that stock and start to think of it as a bad stock, and they will be more likely to overreact to this event.
On the under-reaction side, it may be new and surprising data that people tend to not fully react to. Individuals anchor on previous data, and when new data comes in that’s different than that, they adjust, but they don’t adjust enough. These behavioral dynamics and the type of information that is coming out since the crisis might partially explain the shift in price behavior.
It is important to note that this shift in investor behavior in all likelihood cannot be explained by the positive nature of news that has come out about the economy over the past 10 years. If investors had rational expectations about the news, they would tend to learn over time and pre-empt the positive news, which does not show up as a result in the data.
With markets exhibiting an abnormal amount of calm over the past 5 years (accompanied by an extremely low VIX), it definitely appears slightly anomalous that investors tend to over-react to news since the crisis. Will this change how investors out there trade earnings announcements/analyst reports, and ultimately lead to the end of momentum based funds? Only time will tell if over-reactions are here to stay or just a temporary anomaly in our equity markets.